For a decade Chinese economic planners have effectively subsidized the industrial sector with low electricity prices. The price of electricity – controlled by the National Development and Reform Commission (NDRC) – has been kept so low that the average returns on the assets of electric power producers and distributors have been significantly below the cost of financing those assets. Firms in the industrial sector disproportionately benefit from low electricity prices because their energy intensity is higher than firms in the service sector. These distortions may now be changing.

A recovery for electric power producers

First, policymakers are relying more on markets to price thermal power. Coal is utilized for 80 percent of China’s electricity production and should have a large impact on electricity price. Previously, government controls on coal contract pricing and the price the grid pays thermal power producers squeezed thermal power plants and reduced pressure to raise end users prices.

This system was adjusted in 2013. The NDRC agreed to stop setting a benchmark price for coal contracts between thermal power plants and coal mines. Now the two parties can freely negotiate contract prices based on the prevailing market price for coal.

NDRC also introduced market forces to the price the grid pays thermal power plants (or the “on-grid tariff’). The on-grid tariff will now rise or fall if coal prices change by 5 percent or more.

The price thermal power producers are charging the grid may now be closer to market equilibrium for the first time in a decade. This is reflected by the fact that the return-on-assets of thermal power producers now slightly exceeds the prime bank-lending rate of 5.6 percent – a proxy for the cost of capital – for mostly state-owned thermal power companies (see chart 1).

Electric distributors are passing on more costs to users

Second, grid companies (owned primarily by State Grid and China Southern Power Grid) are now able to pass on more thermal power prices to end-users. In a market environment grid companies should raise prices in response to a higher on-grid tariff for thermal power companies. In China this does not happen because the National Development and Reform Commission (NDRC) controls the price end-users pay the grid.

This has changed with recent reforms. In 2012, NDRC launched a three-tiered electricity pricing system to charge higher rates to households consuming more electricity. In December 2013, National Development and Reform Commission (NDRC) finally expanded the tiered pricing approach to the industrial sector when it announced a three tiered pricing system for the aluminum sector. Non-ferrous metal smelting and pressing – including mostly aluminum – are the third largest consumer of electricity in China after steel production and chemical products.

Reforms have reduced the losses for distributors. In the past two years, the profitability of grid companies has declined as the costs of goods sold for grid companies rose faster than revenues.

However, this is an improvement from the past (see chart 2). The gap between cost growth and revenue growth was higher in 2001 to 2004, and nearly three times higher from 2008 to 2009.

The increased pass through of higher electricity costs to end users can also be measured by looking at the revenues of grid companies per unit of electricity consumer or the effective electricity price. In 2011 the effective electricity price charged by the grid was 0.66 Rmb per Khw, since this has continued to rise to 0.75 percent in 2013.

Big picture of electric power reform

In theory, if electric price subsidies were to be eliminated, as prices become more market determined, they should continue to rise until the return-on-assets of power producers and distributors equals the cost of capital. The gap has narrowed as the weighted average returns on assets of thermal power plants and electric power distributors rose from 0.2 percent in 2011 to 3.9 percent in 2013. But return on assets of the sector is still well below the average prime lending rate, a proxy for their cost of capital (see chart 3).

It is not clear whether progress will continue. In 2008 to 2012, returns were suppressed by the state as part of a broader effort to stimulate the economy following the financial crisis. If coal prices rise once again, the state still has complete control over end user pricing, thus can limit pass-through of rising on-grid tariffs. The 5 percent threshold for annual adjustment to on-grid tariffs also leaves plenty of room to squeeze thermal power producers once again.

On the other hand, if market price reforms to electricity pricing continue, this will likely lead to higher prices. Higher prices will be an additional challenge to a manufacturing sector already struggling with rising labor, capital, and exchange rate costs. Some firms will struggle while others will succeed by focusing more on improving the value of their products as cost savings decline.

Additional price pressures in the manufacturing sector will like slow its growth relative to the service sector. Last year was the first year since 1960 in which the service sector was a larger share of GDP than secondary industry. As China continues to move to a more market determined price for electricity, we should expect the service sector will continue to be the primary beneficiary.